Looking for Extra Yield? The Case for Preferreds
- Preferred stocks and securities offer higher yields than most traditional fixed income investments, but higher returns typically come with higher risk.
- Because they have long (or no) maturity dates, preferred security prices can be volatile. Their higher coupons can help offset potential price declines, but investors should have a long time horizon.
- Financial-sector issuers make up most of the preferred securities market.
Looking for higher yields? Preferred securities are one way to potentially boost the income from a fixed income portfolio without having to wander into the sub-investment-grade end of the credit risk spectrum.
This isn’t to say preferred securities aren’t without risk. As with any investment, higher yields generally mean more risk. Preferred securities are subject to many of the same risks as fixed income securities including interest rate, credit, call, liquidity, reinvestment, purchasing power and market/event risk. But we believe economic conditions currently support the case for considering an allocation to preferreds as part of a diversified fixed income portfolio: Global interest rates are low, we believe the future course of long-term rates looks mild and the economy is growing, albeit slowly. So let’s take a closer look.
What’s a preferred security?
Preferred securities can be considered hybrid investments that share characteristics of both stocks and bonds. Like a common stock, a preferred security can represent an ownership stake in a company, entitling its holder to a share of the profits (in the form of coupon payments), though preferreds usually don’t carry voting rights. Also like stocks, they usually trade on an exchange.
“Preferred” refers to the order in which investors can expect to be paid. Bondholders typically get first dibs on any coupon payments, followed by holders of preferred securities. Owners of common stock get paid out of what’s left. Different kinds of preferred securities—preferred stock, hybrid preferred securities and senior notes—may occupy different places in the payment pecking order between common stocks and bonds.
As far as the bond-like features:
- Coupons: Depending on the type of security, coupon payments could be considered interest or dividend income. Most preferred securities have fixed coupon rates, like a traditional bond, though some have floating rates. Unlike bonds, which typically make coupon payments semiannually, preferred securities tend to pay quarterly. They also have a par value—or face value—which is generally the amount promised to an investor when—or if—the securities mature or are repaid.
- Maturity: Preferred securities generally have long maturity dates, ranging from 30 to 60 years, or no maturity date at all (these are known as “perpetual preferred securities”). Most preferreds are callable, allowing the issuer to retire the security at a set price (usually par) on or after a specific date prior to maturity. That is one source of risk, because issuers tend to call a security when interest rates are falling and they can issue new securities at lower yields, exactly the time that investors don’t want to receive their cash back.
- Weaker guarantees: As noted above, most preferred securities rank below the issuer’s bonds in the order of priority for payment. In a bankruptcy, for example, a company’s bondholders would be paid before holders of preferred securities. Due to this “subordination,” an issuer’s preferred security will generally have a lower credit rating than its senior unsecured bonds.
Higher yields in a (still) low yield environment
Another characteristic preferreds share with bonds is that they may have a rating from a credit-rating agency such as Moody’s Investors Service or Standard & Poor’s. In a world of low and even negative bond yields, investment-grade preferred securities can offer attractive yields. As the chart below shows, the BofA Merrill Lynch Fixed Rate Preferred Securities Index, a broad gauge of the investment-grade preferred securities market, has an average yield to worst of 4.4%, above most other investment-grade alternatives.1
Preferred securities have higher yields than most investment-grade alternatives
Source: Barclays and Bloomberg. Data as of 3/29/2016. High-yield corporate is represented by the Barclays U.S. Corporate High-Yield Bond Index; Preferreds are represented by the BofA Merrill Lynch Fixed Rate Preferred Securities Index; Investment-grade corporate is represented by the Barclays U.S. Corporate Bond Index; Agency mortgage-backed is represented by the Barclays U.S. Mortgage Backed Securities Index; Treasuries are represented by the Barclays U.S. Treasury Bond Index; and International ex-USD is represented by the Barclays Global Aggregate ex U.S. Bond Index.
The average coupon rate of the holdings in the BofA Merrill Lynch Fixed Rate Preferred Securities Index is 6.2%. That’s well above the 4.2% average coupon rate of the Barclays U.S. Corporate Bond Index and just below the 6.6% average coupon rate of the Barclays U.S. Corporate High-Yield Bond Index.2 The high-yield bond index is composed of sub-investment-grade issues, which generally carry more credit risk (that is, the risk that the issuer will be unable to make interest or principal payments).
In fact, over the past five years, preferred securities have been one of the best-performing fixed income asset classes. As the chart below illustrates, preferred securities are just below long-term Treasuries in terms of annualized returns, and they’ve been less volatile than high-yield corporate bonds and emerging market bonds.
Risk and return varies by type of fixed income investment
Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. Treasuries (short-term) are represented by the Barclays Short Treasury Index; Treasuries (intermediate-term) are represented by the Barclays U.S. Intermediate Treasury Index; Treasuries (long-term) are represented by the Barclays U.S. Long Treasury Index; U.S. Aggregate is represented by the Barclays U.S. Aggregate Bond Index; Muni bonds are represented by the Barclays Municipal Bond Index; Corporate (investment-grade) is represented by the Barclays U.S. Corporate Bond Index; Corporate (high-yield) is represented by the Barclays U.S. Corporate High-Yield Bond Index; Preferreds are represented by the BofA Merrill Lynch Fixed Rate Preferred Securities Index; EM bonds are represented by the Barclays EM USD Aggregate Bond Index. The chart above compares the risk and return features of the various fixed income indices. Risk is represented by the annualized standard deviation of monthly returns, and return is represented by the average annualized total return from 3/2011 through 2/2016. Returns assume reinvestment of bond principal and interest and are not adjusted for taxes. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
What about a rise in rates?
Preferred securities, like most other fixed income investments, are sensitive to interest rate changes. Generally, when rates go up, the prices of existing fixed income assets fall (and vice versa), bringing their yields closer to those on securities issued at the new prevailing rate.
How much prices change depends partly on an asset’s duration, a measure of interest rate sensitivity. Assets with longer maturities tend to have longer durations, and the longer the duration, the more sensitive the asset’s price will be to rate changes. Remember that preferreds tend to have very long maturities, or no maturity at all, so they could be in for some volatility if rates rise again.
That said, preferreds’ stock-like qualities also mean they can respond to market factors as well as changes in interest rates. In fact, over the past five years, preferreds have been more correlated with stocks than with bonds.3
So, if interest rates rose and economic growth continued to improve, preferreds might not move much at all. An improving economic outlook could prompt investors to demand less of a risk premium.
(On a separate note: We don’t expect yields on longer-dated Treasuries—which are driven more by growth and inflation concerns than by changes in the federal funds rate—to rise much more if rates go up. Since the Federal Reserve hiked rates by 0.25% in December, the 10-year Treasury yield has actually dropped by 0.5%.4)
High concentration of financial institution issuers
Another thing to keep in mind is that the market for preferred securities is dominated by financial institutions, so sector diversification can be challenging. Preferreds issued by financial institutions make up more than 70% of the BofA Merrill Lynch Fixed Rate Preferred Securities Index (in comparison, financials make up about a third of the investment-grade corporate bond index5).
Given this concentration, the preferred market tends to track financial stocks, as you can see in the chart below. When stock market volatility picked up earlier this year, preferreds also moved, with the average price of the preferred index falling more than 4%. Preferred prices have since rebounded, generally following the path of stocks.6 During periods of market volatility, it’s important to understand that preferred securities may act more like stocks than bonds, and may not give you the diversification benefits that high-quality core fixed income holdings can offer.
Preferred securities may act more like stocks than bonds during periods of market volatility
Source: Bloomberg. Daily data as of 3/30/ 2016.
How to invest?
The preferred stock and securities market is a niche market, and investing in it can occasionally be challenging, in our view. As noted above, there are different kinds of preferred securities, each with its own guarantees and structures.
Because of the market’s relative complexity, we believe investing through an active manager is preferable to investing in preferreds-focused exchange-traded funds that merely track an index. Working with a manager can mean investing in actively managed mutual funds or separately managed accounts that invest in preferreds. Building a portfolio of individual preferred issues yourself is another option, allowing you to find issues that fit your needs. If that seems too daunting, an active manager may be a more appropriate option.
For Schwab clients: One way to find individual preferred securities is by using the Preferred Shares Screener. This allows investors to screen for characteristics including credit ratings and current yield. You can find preferred securities online at schwab.com by going to Research > Stocks > Screeners and selecting "Preferred Shares." To search for preferred securities mutual funds, use the Fund Screener and select "Taxable Bond," and then "Preferred Stock." If you have additional questions, call a Schwab Fixed Income Specialist at 800-942-9084 for help identifying investments that suit your needs.
What to do now
We believe preferreds can be a useful complement to investors' core fixed income holdings, due to the higher yields they typically offer. But they do come with unique risks, so make sure these investments match your risk tolerance. We believe preferreds should be considered only by investors with longer investing horizons. A Schwab fixed income specialist can help you navigate this market and figure out what approach makes the most sense for you.
1Yield to worst is the lower of the yield to worst or yield to call. It's the lowest yield an investor will receive, barring default.
2Source: BofA Merrill Lynch and Barclays data, as of 3/31/2016.
3Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated.
4Source:Bloomberg. 10-year Treasury yield change from 12/16/2015 through 4/6/2016.
5Source: Barclays U.S. Corporate Bond Index. Financial institutions represent 31% of the overall index, as of 3/29/ 2016.
6Source: Bloomberg. Daily data as of 3/30/ 2016; 4% drop was from 12/31/2015 through 2/11/2016.
Talk to Us
To discuss how this article might affect your investment decisions:
- Call a bond specialist at Schwab anytime at 877-908-1072.
- Talk to a Schwab Financial Consultant at your local branch.
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.
Investments in managed accounts should be considered in view of a larger, more diversified investment portfolio.
The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar (USD)-denominated preferred securities issued in the U.S. domestic market.
The Barclays U.S. Corporate High-Yield Index measures the market of USD-denominated, non-investment-grade, fixed-rate, taxable corporate bonds. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
The Barclays U.S. Corporate Bond Index covers the USD-denominated investment grade, fixed-rate, taxable, corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch.
The Barclays U.S. Mortgage-Backed Securities (MBS) Index is a market value-weighted index that measures the performance of investment grade fixed-rate mortgage-backed pass-through securities of Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and Freddie Mac (FHLMC). It includes securities that have 30-, 20-, 15-year and balloon securities with remaining maturity of at least one year and more than $250 million outstanding face value.
The Barclays U.S. Treasury Bond Index includes public obligations of the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index. In addition, certain special issues, such as state and local government series bonds (SLGs), as well as U.S. Treasury TIPS, are excluded.
The Barclays Short Treasury Index is an unmanaged index that measures the performance of U.S. Treasury securities that have a remaining maturity between one and twelve months.
The Barclays U.S. Intermediate Treasury Index is an unmanaged index includes all publicly issued U.S. Treasury securities that have a remaining maturity of greater than or equal to one year and less than 10 years, are rated investment grade, and have $250 million or more of outstanding face value.
The Barclays U.S. Long Treasury Index is an unmanaged index that includes all publicly issued U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value.
The Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.
The Barclays Municipal Bond Index is an unmanaged index that is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year.
The Barclays Emerging Markets USD Aggregate Bond Index includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.
The Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The Global Aggregate Bond Index ex US excludes the U.S. Aggregate component.
The S&P 500 Financials Index comprises those companies included in the S&P 500 that are classified as members of the GICS® financials sector.
Diversification strategies do not assure a profit and do not necessarily protect against losses in declining markets.
Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors. Dividend or interest payments on preferred securities may be variable, suspended or deferred by the issuer at any time, and missed or deferred payments may not be paid at a future date. Investors may incur a tax liability on the deferred income. Consult your tax advisor regarding your specific circumstances. Certain preferred securities are convertible into common stock of the issuer; therefore, their market prices can be sensitive to changes in the value of the issuer's common stock. Some preferred securities are perpetual, meaning they have no stated maturity date. In the case of preferred securities with a stated maturity date, the issuer may, under certain circumstances, extend this date at its discretion. Extension of maturity date would delay repayment of principal on the securities. Prior to investing, investors should carefully consider information on the terms and conditions of the security located in the prospectus, including specific, risks and features, which can be located on the SEC's EDGAR system.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.